A margin loan is a form of gearing. An investor borrows money to invest in approved shares, exchange traded products or managed funds. That investor’s cash or investments are used as security for the loan.
Each different lender has a list of approved securities that specifies the percentage of the value of each investment that can be used as security – the loan to value ratio (LVR). The investor must provide cash or other securities to bridge the difference between this lending value and the total loan.
Investors using margin lending to increase the number and volume of assets that can be purchased. Margin lending helps investors to:
> Diversify – more money to spend means a greater spread of investments; when that portfolio is geared, diversification can reduce the risk that poor returns from one investment will reduce the value of the total portfolio.
> Unlock equity – investors can borrow against existing assets to expand their investment portfolio; no selling one asset to buy another. This has the added benefit of not triggering a potential capital gains tax liability.
> Increase investment returns – gearing magnifies gains – but also losses!
> Increase income – investors can buy high yielding securities and get more dividends from the portfolio because they own a greater number of securities.
> Improve after-tax returns – with margin loans, there is the prospect of tax benefits, although that varies from one investor to another. Such benefits might include:
– a tax deduction for interest payments on the margin loan
– buying a greater number of securities with fully franked dividends
– negative gearing if the expenses associated with the margin loan are greater than the income received.
When an investment portfolio becomes worth less than the margin loan, a margin call results. It can be rectified by the addition of money or securities to the account; however, in the case of a prolonged bear market, the margin call may not be a one off.
When an investor borrows to invest, the margin lender takes security over the investments bought with that loan. These investments can be sold by the lender to repay the loan if the investor is unable add cash or other securities to the portfolio. If the value falls significantly, the investor might lose the assets and still be in debt to the lender.